Pricing of Guarantees

Pricing of Guarantees - 37 liam mckay VHWyqXsWHg0 unsplash

A market guarantee premium must cover all costs assumed by the guarantor including the cost of possible default, cost of capital and the cost of administering the guarantee.


Financial instruments are much in vogue. The Pan-European Guarantee Fund and to a smaller extent the Recovery and Resilience Fund are implemented through financial instruments that seek to leverage private participation. Depending on their terms and pricing, financial instruments may or may not contain State aid. Therefore, it becomes necessary to know when they contain State aid and how much.

Recently, the European Commission approved a Portuguese methodology for the pricing of guarantees [case SA.61340].[1] The purpose of the methodology was to identify a premium that would correspond to a market rate so that the guarantees would not confer an advantage and consequently would be free of State aid. At the same time, a premium that falls below the hypothetical market rate constitutes State aid. So the methodology would also be used to calculate the gross grant equivalent of the aid embedded in guarantee priced at sub-market rates.

Main features of the guarantee

The scheme, named SNGM, was pre-notified in November 2020 and formally notified in May 2021 for purposes of legal certainty.

The national reinsurance fund [FCGM] would cover a share of the risk held by the SNGM, while the FCGM would be managed by Banco Português de Fomento [the Portuguese National Promotional Bank (BPF)].

The proposed calculation methodology only applied to SMEs and established a theoretical market premium for state guarantees, using as guidance point 3.4 of the Commission’s 2008 Guarantee Notice.

It is worth recalling that point 3.4 of the Notice describes how schemes may be structured so as to exclude the presence of State aid. The following seven conditions need to be satisfied:

  1. The scheme is closed to borrowers in financial difficulty.
  2. The guarantees must be i) linked to specific financial transactions, ii) for a fixed maximum amount and iii) limited in time.
  3. The guarantees do not cover more than 80% of the underlying loan.
  4. The scheme is based on a realistic assessment of the risk; the premiums charged are in line with market prices and each guarantee is assessed, on the basis of such factors as the quality of the borrower, collateral, duration of the guarantee, etc.
  5. The scheme has to be self-financing and reviewed at least once per year.
  6. Premiums have to cover the normal risks associated with granting the guarantee, the administrative costs of the scheme, and a yearly remuneration of an adequate capital. The capital has to correspond to 8% of the outstanding guarantees and its remuneration has to be at least equal to the risk premium plus the risk-free interest rate [if capital is not actually provided by the state, the risk-free interest rate need not be charged] [a normal risk premium amounts to at least 4%; the yield of the 10-year government bond may be used as a proxy for the risk-free rate].
  7. The scheme must be transparent.

The Portuguese methodology

According to the Commission decision on the Portuguese guarantee, “(8) the pricing model encompasses three parts:

  1. Cost of Capital
  2. Administrative Costs
  3. Cost of Risk, as a multiplication of Probability of Default (PD) x Loss Given Default (LGD).”

First, the raw risk is linked to credit ratings. “(9) The model considers 12 rating levels, where 1 is the rating with the lowest risk [corresponding to a Moody’s Baa2/Baa3 rating] and 12 the one with the highest risk [corresponding to a Moody’s B2/B3 rating]. For the Cost of Risk calculation, a distinction is made between Individual and Micro Companies, on the one hand, and SMEs, which do not fulfil these criteria, on the other”.

For the cost of capital “(10) the methodology applies a regulatory minimum of 8% and the capital conservation buffer of 2.5% (currently set at 0%). The combined amount of capital is multiplied by a ratings-based risk premium: 4% for rating categories 1-7, 6% for rating categories 8-9 and 8% for rating categories 10-12.”

“(11) This results in current recurring annual cost of capital of 0.32% for rating categories 1-7, 0.48% for rating categories 8-9 and 0.64% for rating categories 10-12.”

It should be noted that this approach is stricter than that of the Commission Notice whereby the cost of capital is a flat 0.32% [= 8% x 4%], regardless of the credit rating of the company receiving the guarantee.

With regard to administrative costs, the Portuguese methodology breaks them down in several sub-costs and computes them “(12) as a rolling average of the costs incurred by BPF in the initial cost of risk assessment, the costs associated with monitoring the risks, and the costs of granting and administrating the guarantee. They include both personnel costs, general administrative expenses and amortisations of systems and software.”

“(13) For the years 2016-2020, these costs have amounted to respectively 0.42%, 0.41%, 0.44%, 0.43% and 0.15% of the outstanding (live) guaranteed amounts. As a result, the calculation methodology would use a fixed cost of 0.368% in its first year, to be recalculated on an annual basis.”

Lastly, the cost of risk is “(14) computed as the product of annualized PD and LGD and distinguishes, first, between company type (Individual and Micro Companies versus other SMEs) and, second, by rating category.”

The annualised PD ranges from 0.250% in category 1 to 5.854% in category 12. A long-term average LGD of 77.34% is used for these companies. This makes the cost of risk in terms of Expected Losses [EL] to vary from 0.193% to 4.527%.

For SMEs the annualized PD ranges from 0.148% in category 1 to 3.298% in category 12. A long-term average LGD of 70.16% is used for these companies. This makes the cost of risk in terms of EL to vary from 0.104% to 2.314%.

“(19) Portugal has arrived at these PD figures using a six-step process: segmentation by client type and rating; outlining the reference period for each segment; counting historical defaults; computing a marginal default rate; estimating a default probability from a best fit curve; annualize the default probability from the weighted average portfolio maturity.”

“(23) The LGDs have also been derived by a multi-step process: a segmentation by historic recovery strategy (cure, liquidation of loan, sale of collateral, inconclusive recovery strategy); the computation of the sum of discounted recoveries to establish the absolute loss and the relative losses of each strategy, the estimation of the probability of each recovery strategy. The LGDs are then calculated, per segment, by a probability-weighted summation of the discounted (absolute and relative) losses of each strategy. The LGDs are re-calibrated on an annual basis using newly available data.”

Pricing of Guarantees - mockup of a book on a pile of colorful books 30915

Guarantee premium

The total guarantee premium is derived by summing the components for cost of capital, administrative costs and the cost of risk for the appropriate category. For individual and micro enterprises, the total premiums range from 0.881% in category 1 to 5.535% in category 12. For SMEs, the total premiums range from 0.792% in category 1 to 3.322% in category 12.

In addition, the scheme ensures that no aid benefits are obtained by the lenders of the guaranteed loans in the following way: “(28) For each loan covered by a guarantee, with a notional amount greater than EUR 1.5 million and a maturity of five years or less; or for each loan with a notional amount greater than EUR 1 million and maturity more than five years, Portugal and BPF will compute the implied Credit Default Swap (“CDS”) rate of the client from the charged interest rate according to the formula

CDS(Client) = ((R – F) – G x CDS(Portugal)) / (1-G)

where R is the effective interest rate charged to the client; F is the sum of the lender’s funding and administration cost; G is the ratio of loan amount being guaranteed (usually 80%).”

“(29) Portugal and BPF will then compare the computed implied CDS rate to the guarantee premium it is charging under the methodology. If the implied CDS rate deviates from the guarantee premium by more than 100 basis points (1%), then BPF will either ask the lender to lower the effective interest rate so that the deviation between the implied CDS rate and the guarantee premium is less than 100 basis points; or, if no lender is willing to offer the guaranteed loan at such an interest rate, BPF will adjust (increase) the required guarantee premium so that the deviation between the implied CDS rate and the guarantee premium is less than 100 basis points.”

“(31) To avoid abuses either by the lending bank or the loan guarantee applicant, the funding cost of the lender will be computed realistically, and the administration cost will not exceed the administrative costs charged by BPF”.

“(32) The methodology will also be used for calculating the gross grant equivalent (“GGE”) in guarantee schemes by using it to establish a theoretical market premium (i.e. the premium that should be charged in an equivalent non-aid scheme), as described in the Guarantee Notice. The GGE is determined by subtracting the actual guarantee fee charged to the corresponding theoretical market premium.”

Commission assessment

The Commission based its assessment on the seven conditions in point 3.4 of the Guarantee Notice.

“(36) The Commission considers that the relevant conditions listed under section 3.4 (a)-(c) and (e)-(g) of the Guarantee Notice are fulfilled by the proposed methodology.”

“(37) As regards the self-financing requirement under section 3.4 (d) of the Guarantee Notice, the Commission takes positive note that Portugal has included an adequate remuneration of capital, differentiated by rating category, as part of the demonstration of self-financing requirement, to avoid cross subsidizing between rating categories.”

“(40) According to the Guarantee Notice, a normal risk premium for equity amounts to at least 400 basis points […] Portugal will apply risk premiums of 400 to 800 basis points, as a function of the rating category, thus adhering to the requirement of the Guarantee Notice.”

“(41) The Commission considers that this approach reflects the fact that the cost of capital, and hence the applicable risk premium, is often a function of the risk associated with the exposure of a guarantor.”

“(43) The Commission further notes that the administration costs are based on realistic historical estimates and considers using a rolling five year average a realistic way of calculating cost remuneration.”

“(44) As regards the cost of risk estimation and the overall appropriateness of the remuneration in line with section 3.4(d) of the Guarantee Notice, the Commission asked Portugal to provide a historical analysis of losses per rating category over smaller time intervals to demonstrate that the pricing methodology would not lead to a cross-subsidizing between rating categories and would be sufficiently robust to avoid losses even over those smaller time intervals, while – on average – generating a sufficient remuneration of capital.”

“(45) The Commission notes positively that Portugal has verified that the proposed guarantee premiums would have provided for an adequate remuneration of capital for each rating category over each three-year interval in the historical dataset, thus ensuring statistical robustness of the pricing methodology.”

With respect to preventing lenders from benefiting from the guarantees, the Commission noted that “(53) the lending bank will, as a commercial operator retaining 20% of the amount at risk, take into consideration all relevant factors in terms of credit risk to ensure sufficient remuneration for the risk it undertakes. Specifically, if the lending bank considers that lending to a specific client is more risky, it will demand a higher interest rate […] the SNGM will require a higher guarantee premium for the lenders [sic] [it should be “borrowers”] that pay a higher interest rate (because they are riskier). Therefore, as part of its governance mechanism, the SNGM will increase the required guarantee premium if necessary after concluding that, on the basis of all relevant credit factors, the client can obtain credit for the guaranteed loan only at a higher interest rate.”

“(54) The mechanism thus ensures that, following the conditions described in recital (28) for loans with a notional amount of more than EUR 1.5 million, both the SNGM and the bank will perform an assessment of the risk of each new guarantee on the basis of all the relevant factors (quality of the borrower, securities, duration of the guarantee, etc.), in line with the second paragraph of section 3.4(d) of the Guarantee Notice.”

“(58) Finally, the Commission notes positively that the governance structure will also ensure that the measure does not provide any selective advantage to the lender, by limiting the size of the coupon as a function of the CDS rate of Portugal and the guarantee premium payable by the company applying for the loan.”


The Commission concluded that the notified methodology was rigorous, in line with the Guarantee Notice and priced risk appropriately. In addition, the methodology made possible the calculation of the aid element in state guarantees with premiums below the hypothetical market rate.

The Commission approved it for a period of four years.

[1] The full text of the Commission decision can be accessed at:

Photo by Liam McKay on Unsplash



Phedon Nicolaides

Dr. Nicolaides was educated in the United States, the Netherlands and the United Kingdom. He has a PhD in Economics and a PhD in Law. He is professor at the University of Maastricht and the University of Nicosia. He has published extensively on European integration, competition policy and State aid. He is also on the editorial boards of several journals. Dr. Nicolaides has organised seminars and workshops in many different Member States, and has acted as consultant to several public authorities.

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